Conventional wisdom posits that higher interest rates lead to higher borrowing costs and eventually to slower growth and lower inflation. Arabian Gulf central banks wasted little time in following the Federal Reserve’s interest rate increase last week, maintaining a commitment to the US dollar peg. Because of these pegs to the dollar, the region must stay in line with US monetary policy or risk debilitating capital outflows.
But there is a second part to this story – while the dollar peg is a front-and-centre element of economic strategy, beneath the surface the GCC countries need to persevere in implementing structural reforms.
Let’s start with a look at the significance of the Fed hike.
Almost all pundits are correct in pointing out that higher interest rates for the GCC are taking place while oil prices are still low and the greenback is gaining in strength, which can put pressure on growth. Arguably, we have some clarity as to how many rate increases the Federal Reserve could undertake going forward – perhaps two or three next year. Oil prices, as I argue in previous articles, are bound to rise to US$60 per barrel sometime next year and $70 in 2018.
However, money market rates in the Gulf barely rose on Thursday after the Fed tightened policy, a sign that the region’s worries over a bank funding squeeze might have eased because of higher oil prices and international borrowing. Saudi Arabia’s government opened a new channel to fund its budget deficit with an epic $17.5 billion international bond issue in October. Another foreign issue in the first quarter next year will reduce the need for Saudi banks to finance the deficit.
Late last year and for much of this year, money rates soared to multiyear highs, alarming banks and threatening to raise corporate borrowing costs, as governments’ oil revenues shrank and flows into banks diminished. Pressures on the banks remain but in the last two months the situation has improved in several ways. Brent oil is around $55 a barrel compared with the year’s average of about $45. Steps by the Saudi Arabian Monetary Authority (Sama) in recent weeks – such as the introduction of new market tools to inject funds – can act as a mitigating factor against a US hike as well as increase liquidity. In turn, better liquidity in Riyadh could ease pressure in other regional centres.
Looking ahead, Saudi Arabia’s state budget, expected to be released in a few days, could help determine money rates’ direction by showing Riyadh’s spending and borrowing intentions.
All things considered, upward pressure on market rates could ease in the Gulf next year.
Five of the six GCC countries have maintained their dollar pegs for decades. This choice of exchange rate regime has to be seen in the context of the structural characteristics of the GCC economies, in particular the importance of the oil sector in GDP, exports and government revenue. At present, oil and gas production contributes about half of GDP and three quarters of exports and government revenue. The primary challenge for GCC economies is to diversify their economies and further develop the non-oil private sector to create employment opportunities for their rapidly growing national labour force.
Notwithstanding the importance of the exchange rate over the medium term, the region is primarily facing long-term declining economics, if reforms are ignored. The GCC in a low oil price environment needs to find new growth policies. During high-growth episodes, productivity contributes more than capital and capital contributes more than labour, with a tendency for relatively higher capital and productivity contributions to coexist, particularly in advanced economies and emerging markets in Asia and Sub-Saharan Africa.
The region requires a new growth model. Traditionally, high-growth periods are characterised mainly by significant labour contributions to growth, which reflects a policy that favours imported labour and relatively higher wages for public sector employees. The positive association between capital and productivity contributions appears to be absent, except in Kuwait and Oman, suggesting that the link between productivity and investment is missing; when comparing high and non-high growth episodes, growth differences are mainly explained by labour contributions in Bahrain, Qatar and the UAE, and by productivity increases in Kuwait, Oman and Saudi Arabia. The median productivity contribution to growth in GCC countries is lower than for all other groups of countries, including emerging oil exporters. High-growth episodes occurred mainly during periods of higher oil prices; if the 2003 to 2014 period were excluded, only the UAE would have recorded a high non-oil growth episode. As documented earlier, for most GCC countries and other non-oil exporters, growth slowed after the 2009 financial crisis.
Although rising interest rates find the region in a different economic cycle than the US, the region’s economies will be more affected by the pace of structural reforms than simply the cost of capital. The economic slowdown facing the region increases the need for additional structural reforms to support growth, boosting productivity, catalysing private investment and creating high-paying private sector jobs for nationals.
There is a large body of empirical analysis that finds a positive relationship between a number of structural reforms and various growth drivers. Some of these stress the need for price stability, which allows for a better assessment of relative prices conducive to better investment decisions, openness to competition from abroad to facilitate international transfer of better technologies, and the creation of incentives for efficiency.
Others include a competitive business environment, labour market efficiency and public infrastructure and improvements in investment efficiency in the GCC. The IMF reports that higher quality of institutions, such as public governance, legal systems and property rights, are associated with more efficient allocation of resources, which in turn can boost aggregate productivity and can also build confidence in the economy and stimulate investment and employment. Interest rates are important but structural reforms are seminal to growth over the long term.
John Sfakianakis is the director of economic research at the Gulf Research Centre in Riyadh
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